A Tax Strategy That Won't Hurt

President Obama has signed into law a bill that raises the debt ceiling and cuts spending. Democrats are reeling because revenue increases were not part of the first round of the debt-limit deal. The initial roughly $1 trillion in deficit reduction over 10 years will come entirely from caps on discretionary spending, both defense and domestic.

After months of contentious negotiations, it may appear that Republicans won the debt battle by keeping taxes off the table. But Democrats won as well by keeping Social Security and Medicare benefits off-limits. Meanwhile, policymakers are no closer to making the tough choices needed to get federal deficits down to economically sustainable levels. Those choices involve fundamental reforms to our entitlement and tax systems -- once again put off for a later day, perhaps as part of the second round of deficit reduction in the debt-limit deal.

Frankly, neither side seems ready to support specific proposals on either how to cut entitlement spending or how to raise revenues. Even the brave House budget chair, Republican Rep. Paul Ryan of Wisconsin, has never spelled out how his proposed reductions to Medicare spending would translate into what beneficiaries would have to give up in services.

Policymakers on both sides of the aisle and both ends of Pennsylvania Avenue weren't ready for tax reform. Lots of unresolved disagreements on tax policy remain:

-- Republicans vs. Democrats: They can't agree on the role of revenues vs. spending in deficit reduction. This is usually thought to be the biggest sticking point -- the fundamental disagreement over the proper role of government.

-- Republicans vs. Republicans: They can't agree about what the "No New Taxes" pledge means. What counts as a tax increase?

-- Democrats vs. Democrats: They can't agree about who should pay higher taxes. Should it be just millionaires, billionaires and corporations, or should higher-income taxpayers be more broadly defined, such as those with incomes of $250,000 or more? Or should even lower- and middle-income taxpayers pay more, too?

Policymakers will have to work out at least some of these differences soon because taxes have to be at least part of the ultimate solution to our nation's fiscal challenges. The longer-term pressures on federal spending come from the aging of the baby boom generation and rising per-capita health costs, and no one is contemplating real benefit cuts for anyone in, or even close to, retirement.

Projections by the nonpartisan Congressional Budget Office make it clear that upcoming choices about tax policy, and in particular expiring tax cuts, are a huge factor in the fiscal outlook over the next few decades -- making the difference between economically sustainable deficits vs. unsustainable ones.

What we need to do is raise as much revenue as we would if the Bush tax cuts expire. And if we don't have the political will to let them expire, which apparently legislators do not have, then Congress and the president should at least commit to offsetting the cost of any extension of the cuts.

The debt deal leaves that as a possibility for the second round, as all policy options will be back on the negotiating table for the "super committee."

Reform can be achieved in many ways, but the strategy most likely to appeal to Republicans and Democrats is to raise revenue through broadening the tax base in order to pay for lower marginal tax rates. Reducing so-called tax expenditures -- exclusions, deductions, credits, and preferential rates in the tax code -- is easy to do progressively, by cutting the preferences relatively more for the rich.

But does the second bite at deficit reduction -- to take place in the holiday season -- come too soon to figure out a major tax reform in time?

Here's one way it could work out:

1. By the Thanksgiving deadline, the second-round super committee recommends legislation that would obligate Congress and the administration to strict pay-as-you-go rules on any future extension of expiring tax cuts. The pay-as-you-go rule means that any proposal includes a method to offset the cost, so the proposal does not add to the deficit.

This would include a promise to pay for any extension of any part of the Bush tax cuts at their next expiration date, which is the end of 2012. Relative to current policy, this would save $2.5 trillion over 10 years, and relative to Obama policy, this would still save $1.8 trillion.

2. At the same time, the super committee could identify and bring up for vote specific proposals to raise revenue by reducing certain tax expenditures in fair and economically efficient ways, providing a down payment on the offsets required for the future tax rate extensions. President Obama's proposal -- made in all three of his budgets thus far -- to limit itemized deductions to 28% is a good example.

This would give policymakers another year to develop and debate specific tax reform proposals that would fully comply with the pay-as-you-go rule on the Bush tax cuts.

Such a strategy would recognize the disagreements between and within the political parties about tax policy's role in deficit reduction, and would set up steps to help resolve them. And it would force policymakers into intensive tax policy therapy for the next year and a half. They clearly need it.